“Adversity is neither friend nor foe. It is a common acquaintance that is desired less and rewarded most when embraced.” – Carolyn Wells (For a print version of this report, click here.) An essential tool for investors is the ability to understand what’s happening next. Equally important is knowing what to do once things have changed. Adaptation isn’t easy, and not without risk, but rewards will inevitably only come to those who embrace the challenge. The range and depth of change in commercial real estate is already significant, and it may only be getting started. NAREIM leaders gathered in Chicago this fall to discuss change and adaptation in commercial real estate and to ask a few provocative questions. Three of them are shared below: How can the value of retail be better understood? Conventional wisdom holds that retail is a disaster due to oversupply, numerous big store closings, bankruptcies and a steady loss of sales to the Internet. That may be an overstatement of retail reality. Many overlook higher quality retail space where there is strong demand and “virtually no supply in the market”, according to Shobi Khan, President and COO of GGP. “There are currently 7.5 billion square feet of retail in the United States – the equivalent of 24 square feet per person. Of that 24, only 4 are considered high quality.” As one would expect after more than eight years of recovery, retailers in the highest quality locations are doing exceedingly well – and willing to pay strong rents to be there. Overall, in recent cycles too much retail may have been built, ranging from the once popular big boxes to class B and C regional malls and neighborhood centers. Uses and formats are certainly changing as e-commerce continues to take a significant share of business out of certain categories, but it may be misleading to declare all retail as obsolescent or soon to be so due to the Internet. Not all dead or underperforming malls are destined to become entertainment venues or farmland. The constant barrage of negative headlines are misleading as they use a very broad brush – and actually may be depressing pricing below actual value. Leslie Lundin of LBG Real Estate Companies discussed a mall that LBG acquired in Richmond, California within view of the Pacific. “The acquisition price, we felt, was below any reasonable valuation. That may be due to what everyone is thinking, versus what is reality”. Fear of retail is preventing many investors to consider the value of the property itself. And of course, at depressed pricing, any number of repositioning or renovation strategies becomes viable. The relationship between brick and mortar and e-commerce as well is also more complicated than it seems. Of the $4.6 Trillion spent in retail last year, only 10% was online. Plus, online isn’t purely taking away sales from traditional retailers – it is quite often just another channel for them to sell. According to Greg Maloney, President of Retail for Jones Lang LaSalle, “As retailers better understand the relationship between brick and mortar stores and online purchasing, they combine their in-store and online efforts, ‘up their game’”. Brick and mortar stores are now flagship locations plus e-commerce shipment centers, thereby increasing the value of their real estate. E-commerce is a part of physical retail, not the end of it. Mr. Maloney predicts that, “In 5 years, we won’t even be talking about e-commerce as a separate category.” Mr. Kahn strongly recommended evaluating total sales rather than sales per square foot when trying to understand a real estate asset. Numerous large retailer store closings might appear to be purely negative – but with larger stores cut up into smaller stores, there is ample opportunity to increase the yield on a given asset. Leslie Lundin recommended that we “think about merchandising and leasing space a completely different way.” The time may have come for specialty leasing to vendors; limiting long-term leasing and increasing the number of ways to monetize a given asset. The value has not gone away; it’s simply hiding behind the fear of change. Industrial Real Estate is on a Tear – Why? It’s a good time to own industrial space – but not just because of e-commerce fulfillment centers. Michael Caprile, Vice Chairman of CBRE, Inc., jokingly pointed out: “Everybody thinks the run up in pricing and the cap rate compression is due to the abundance of capital, it’s actually about rent growth; I don’t have to lie about it anymore! This is a simple business, it’s about supply and demand and in this cycle the supply is in check for many different reasons and nothing’s getting overbuilt!” According to Michael Brennan, Chairman of the Brennan Investment Group, “there are opportunities in industrial unlike any time in recent years, in great part because there are two worlds at the same time using space. Traditional warehouse distribution tenants are upping their demand for space while at the same time on-line retail distribution, data centers, and domestic robotic manufacturing are also absorbing space.” The rationale behind what’s driving this two-headed upward trend in industrial real estate seems quite clear. Retailers now know that a physical combined with strong logistic industrial occupancy is the key to competitive advantage, creating a whole new need for industrial real estate. Consumers aren’t concerned with where their good are coming from, and as such, the industrial real estate market is evolving to meet a growing number of needs. According to Ben Conwell, Senior Managing Director of Cushman Wakefield, “We constantly need to remind ourselves that when things change at the store level it also disrupts what happens upstream, dramatically changing supply chains.” How goods get from manufacturer to consumer matters, and that supply chain changes as consumer expectations and logistics processes transform. Whether a retailer has a bricks and mortar presence or not, they are all investing in the next level of logistical capability and flexibility. According to Rene Circ, Director of CoStar Portfolio Strategy, industrial demand is also moving physically. “In the western United States, goods primarily move by train that go to a set number of places, while in the east, moves products by trucks that can go anywhere. As inventory management and logistics improve, more warehouse and distribution space is getting built and used in the East, where most of the consumers are. This creates new spaces in non-industrial markets that are closer to the consumers.” As large retail vendors strive to dominate “the last mile”, industrial spaces in every populated market have become crucial as part of the logistics network. Logistics, however, are not the only use absorbing space. Demand from manufacturing is reaching into assets now functionally obsolete for shipping. Mr. Brennan pointed out that “manufacturing, which includes data and robotic production, uses half of all industrial buildings in the United States; distribution uses about one fifth. So that’s an important aspect for the future of the industrial business model.” Manufacturers need more space, logistics need more space. It’s a perfect storm. What signals are we listening to? Should we consider changing our focus? Joshua Scoville, Senior Managing Director for Hines, made a compelling presentation around different ways to understand where markets are going – and how to separate the noise from the signals. “Before I joined Hines, I used a fairly common economic method to forecast, understand, and predict commercial real estate markets. The basic methodology has been around for quite some time and goes something like this: take a job growth forecast, convert it to commercial real estate demand by some sort of usage factor, forecast supply by tracking what’s under construction and anticipating future deliveries, and you have a pretty good idea about what’s coming in the future in terms of vacancy rates and rent growth. The resultant NOI forecast then gets capitalized by one’s expectations of interest rates and risk premiums.” It works pretty well some of the time but can break down significantly when the economic forecast is missed, which usually tends to happen at turning points in the business cycle. When he joined Hines in 2011, he was asked to solve a specific problem – how can an investor avoid investing too late in a growth cycle or be too hesitant to invest at the bottom? In answering that question, he came across something interesting. “We analyzed over 20,000 data points across markets and assessed the observable indicators that had the biggest impact on future price charges. The evidence pointed to a number of mistaken methods of forecasting value; beginning with economic forecasts. The mistake is to listen to the noise – when markets are growing quickly we assume they will grow fast in the future and when a market isn’t growing very fast we assume it won’t...and yet, there is NO relationship between trailing economic growth and future price growth.” As Hines looked past economic forecasting as its guide for future market performance, it became clear that there was stronger signal which utilized market pricing at the onset of an investment. Predicting future market performance is always difficult due the wide range of variables, cultural, political, and economic, and it is tempting to get too caught up in a narrative about what may or may not happen in a market or sub market – but there is an alternative. Focus instead on what the price is saying. “When prices in any particular market are too high, something is out of balance.” According to Mr. Scoville, “investors should focus on understanding the anatomy of a cycle; the combination of asking ‘how long, and by how much, do prices rise?’ as well as ‘how much more price growth versus the initial pricing can be expected and in what amount of time?’” Can price tell us more than an economic forecast? Is it a more reliable indicator? What if a prediction of an asset’s value in 5 years was even 10% more accurate than it is today? Would that make for better risk adjusted returns? In an environment where everything is changing – politics, technology, global investors – all have the potential to disrupt what and how things are done in real estate investment management firms. Certainly, the assets we invest in, whether its retail and industrial –or office, multi-family, hospitality and others are all undergoing disruptive change at the “street level”. And our investors are also changing how they look at things and what they require of us as managers. The fact is, we are changing whether we like it or not. No one knows precisely how everything will work out – so the imperative is there for everyone to ask good questions. Keep asking.